INTERNATIONAL BUSINESS

Case Study: Argentina Currency Crisis

During the 1980s, the Argentina economy was characterized by hyperinflation,international indebtedness and debt defaults, and recessions. In the early 1990s,the Argentina government introduced a series of economic and monetary reforms,including fixing the Argentina peso to the U.S. dollar at a rate of 1 to 1. Under thisarrangement, Argentina could only print pesos if it had U.S. dollar backings (note:this monetary arrangement is referred to as a currency board).Under this currency board arrangement, Argentina was only able to expand thepeso portion of its money supply in relation to its net inflows of U.S. dollars(resulting from trade growth). The policys impact on inflation was almostimmediate; the inflation rate went from 2,300% in 1990 to 25% in 1992 and to lessthan one percent b y 1996 (see exhibit 1).The Argentina economy, however, did not fare as well. The restrictive currencyboard policy resulted in rising unemployment (up to 16% in 1996) and sloweconomy growth (recessions in 1995 and 1999-2000).As part of the 1991 reforms, the Argentina government permitted residents to holdtheir money deposits in banks in either pesos or U.S. dollars. This was seen aspromoting confidence and discipline in the banking and political system.However, the recession which began in 1999 proved to be the demise of thecurrency board and the exchange rate regime. The recession which lastedthrough 2001, resulted in massive government deficits and a general perceptionthat the peso had become overvalued (recall the fixed rate was 1 to 1).As economic conditions continued to deteriorate and as the pesos worth becomemore and more uncertain, a massive conversion of pesos into U.S. dollars withinthe Argentina economy began; eventually leading to capital flight out of the countryitself. The government responded by closing all banks on December 1, 2001 andthen limiting the withdrawal of funds from banks and the conversion of pesos intodollars.The social repercussions of the governments response were dramatic. Riots tookplace in the streets of Buenos Aires in December. The President, Fernando de laRua was driven from office and his successor, Adolfo Rodriguez Saa, was alsoforced out of office after one week on the job.Saa was succeeded by Eduardo Duhalde, who on Sunday, January 6, 2002, in hisfirst act of presidency, devalued the peso from Ps1/1$ to Ps1.40/1$. The marketswere not impressed with this new rate and on Monday, February 11, 2002, theArgentina government moved to a floating rate regime. Over the course of time,

the peso began a period of depreciation, eventually settling around 3.5 (see exhibit2).Exhibit 1: Inflation in Argentina, 1980 - 2001

Exhibit 2: Peso Exchange Rate, January 2001 December 2002

CASE ANALYSISArgentina was rated as one of the worlds 10 richest countries in the beginning of thetwentieth century. But in 1980s inflation plagued the country and as a resultArgentina lost trust in the peso and invested in U.S. dollars and shipping their capitalabroad. To solve this carols Menem in 1989 took control of the country and set out toimplement free market reform and to restructure monetary and economic policies.He tightened fiscal management and also established the convertibility law whichpegged the Argentine peso 1:1 with the U.S. dollar, but the governments ability torespond to external shocks was severely reduced. In effect, Argentinas exchangerate and monetary policies were determined de facto by the United States, andArgentinas interest rates were determined by the U.S. Federal Reserve. When worldcommodity prices declined, the U.S. dollar, and hence the Argentine peso,strengthened against other currencies. Concurrently, Argentinas main tradingpartner, Brazil, devalued its currency. As deflation set in, both the Argentinegovernment and many private companies found it difficult to pay their debts. Taxrevenues fell, while public spending increased. Interest rates payments wentprimarily to overseas investors, thus further draining the economy. When Argentinebanks were pressured to buy government bonds, a bank run ensued. Following thegovernments default on its debt, the currency board was abandoned, and the pesowas allowed to float against the dollar. In the latter half of 2002, the Argentine pesowas trading at about 27 cents to the dollar.

1) What has been Argentinas experience with the IMF? Has the IMF beenhelpful or not?AnswerArgentina has had a somewhat tumultuous relationship with the IMF. Initially whenthe country sought help from the IMF, the IMF refused saying that Argentina wouldhave to restructure its banking system, fiscal policy, and exchange rate policy.Eventually the IMF did grant loans to Argentina, but then was difficult to negotiatewith when Argentina had trouble repaying those loans. Argentina allow to payinterest only on $ 21 billion debt over the next three years to repay most of the debt,including overdue interest, Argentina proposed a plan to its creditors asking them towrite off 70 percent of the present net value of their government bonds .The IMFand Argentina did finally agree to terms, this way Argentina closed on the biggestdebt restructuring in history with the help of IMF however, both are working toestablish a long term relationship.2) How has the fall in the value of the peso affected business opportunities forcompanies

doing business in Argentina and in exporting and importing?

AnswerThe biggest effect of the fall in the value of the peso for companies doing business inArgentina was hyperinflation. The central bank printed pesos to keep banks solventbut this led to increase inflation. Also, companies with dollar denominated debt werebadly hurt as the cost to repay that debt escalated rapidly. In 2003 new president ofArgentina nester Kirchner economy of Argentina rebounded significantly the countryexperience hyperinflation after the abandonment of the pesos peg to the dollar; thedevaluated peso is now one of the causes of the economy recovery. The pesos weretrading at 0.9920 pesos per dollar on December 31, 2001, but it fell to 3.39 pesos on

December 31, 2002. Next few years the peso is nearly 70% cheaper against thedollar than it was in the 1990s, resulting in increased exports of farm product andother commodities. The devaluation has also resulted in new foreign directinvestment and increased business with Brazil. The declining peso helped exportersto be more competitive but made the prices of imported goods increase faster thanthe prices of domestic goods.

3) Should HSBC invest more money in its operations in Argentina? What

factors should they monitor as they make their decision?AnswerHSBC should continue to be cautious in its approach to increased investment inArgentina HSBC is one of the top banks in the world in foreign-exchange trading in1998 HSBC entered in Argentina .in their first year of operation the bank had loss of$13 million but earned a profit of $67 million in 1999 and expected profits tocontinue growing at 100 percent but due to the depreciation of the peso in ArgentinaHSBC forced to rethink loans and to decide if the political and economic instabilityof the country was worth the risk of continued operations. Although the situationappears to be stabilized, it is still potentially volatile. The company should monitorthe governments actions carefully, particularly its actions regarding the repaymentof foreign debt. Also, if the government requires that dollar denominated loansissued by HSBC and other banks in the past be allowed to be repaid in Pesos, HSBCshould be very reluctant to issue any more dollar denominated loans. After sufferinga $210 million loss in 2002, the Argentina subsidiary of HSBC recorded profit of$48 and$156 million in 2003 and 2004, respectively.